Monday, 8 June 2009

Information based finance

Without good data, it is rather hard to do good analysis. Therefore if accounting standards are sensible, they become invisible: investors use the data, and take it for granted. But if accounting standards are bad - if they allow reporting companies to conceal material facts - then the users of financial statements are put at a huge disadvantage. Credit rating and securities analysis becomes a lot more difficult. This is why the basic test for accounts is still 'are they true and fair?'

I think the major accounting standards setters, the FASB and the IASB, have a very difficult job to do. They are subject to intense, well resourced lobbying from the financial services industry. Moreover, being accountants, they are not experts in all of the products they have to write rules for.

The recent news here is deeply depressing. On Sunday, the observer reported that the IASB may lose the power to make accounting standards in Europe. This is pure politics: the banks have lent on the European commission, and the commission is leaning on the IASB. The IASB is trying to hold the line, but the pressure to allow banks to lie about the value of their balance sheets is considerable.

In the US, things are just as bad. Today FT alphaville picks up a story from the WSJ that the FASB is coming under huge pressure to relent on the reclassification of off balance sheet vehicles. This comes after the shameful capitulation of the FASB on fair value.

The problem here is that one side - the issuers of financial statements - is well organised and the other - the readers - isn't. It would be a great shame if the result of the asymmetry was a permanent degradation in the quality of financial information. But right now, 'true and fair' seems further away than ever.

Update. Floyd Norris has an excellent post on the flexibility that the current loosened US rules give in the NYT. The key point is that if a sale is 'distressed', it can be ignored for the purposes of fair value. One fund bought more of a security that they already owned, and were marking at $98.93, for $9.50. They then
contacted the selling broker-dealer to determine whether the sale was “distressed” (and thus could potentially be disregarded for purposes of determining the fair value of the security). On May 28, 2008, the broker-dealer responded that the security was “not coming from a distressed seller, just one that wanted to get out.” Notwithstanding this response, the Ultra Fund’s portfolio management team informed the Valuation Committee that they believed the sale was distressed
(Quote from SEC litigation against the fund.)

Now, admittedly this is illegal and I am not claiming that the large banks would go this far. But it does illustrate how valuations can be manipulated once you are allowed to ignore current transactions.



Blogger Dave said...

Why are the "readers" not organised? It might be that buying institutions think that they have a competitive advantage in NOT having accounting transparency, since they have the resources to make sense of it all and can also talk to the management directly.

I liked some of your earlier posts that focused on the "game theory" aspects of market behaviour (was it too much to see an echo of "Machiavelli" in your blog title?) and I think you could use this discipline here to help to make sense of this issue.

12:16 am  
Blogger David Murphy said...

Thanks for the comment Dave.

I think it is a herding cats problem. If the top ten banks in the world, say, want to change accounting standards so that they can lie about their asset values, that lobbying is easy to organise and well-resourced when it is. The top ten buy side firms cover much less of the market, and do not have a history of aggressive lobbying. Nor do they have captive regulators willing to argue their cause.

It would be interesting to compare the government relations teams in the largest banks with those in the largest asset managers, insurers and pension funds. I know that the former have tens of people with great contacts in government, regulators, and standard setters. The latter I suspect are much less well resourced.

12:32 pm  

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